Inflation Explained
Have you heard of the Weimar Republic? No, it is not West of King’s Landing as it were some mythical place in Game of Thrones. Zimbabwe perhaps? How about Venezuela? In the past two decades Zimbabwe and Venezuela have made the news in relation to how their currency collapsed and how hyper inflation impacted their economies.
We are not at that stage in the UK and US so you can breathe a sigh of relief. In this article we will take a look at what inflation is, how rising inflation can have an effect on your portfolio as an investor and the economy at large.
As always this is not financial advice and you should seek advice when necessary.
What is Inflation and why does it happen
Inflation is the rate at which the cost of goods and services increase over a period of time. In other words, it is the decline in the purchasing power of the currency in a particular country or region.
This means for a number of items or particular service in an economy, you will need a bit more money to purchase those same goods or service in a few years.
For example an inflation rate of 2% over a period of a year means the same item you bought last year would cost 2% more. Let’s say a cup of coffee costs $2 in the previous year — if the inflation is 2% higher compared to the last year, it will now cost $2.04
What causes Inflation and where does it come from
An increase in the amount of currency in circulation is the cause of inflation and this is observed in different ways in different economies. When money is printed by the Central Bank for various reasons, the money supply increases and a consequence of that is the value of the money is lower. The currency is devalued so it will require a more money to purchase the same assets over time.
You may argue that the price of an asset is inflated to an extent in the sense that a house has not gone up in value by $20,000 five years for example, but rather you need $20,000 more money to purchase the same house.
With more money slushing around in the economy, debt is cheaper so people borrow more and spend more in places such as the stock market, crypto currencies or whatever takes our interest.
Excess money supply is not the only cause of inflation and here are other causes of inflation.
Demand Pull Inflation: Causes and Example
In this situation demand is growing faster than supply and results in an increase or ‘inflation’ in prices to meet demand. This rise is driven by consumers because the demand for a good or service is greater than the supply. Subsequently when the good is available, consumers are willing to pay a bit more for the products thereby inflating the price.
Cost Push Inflation: Causes and Example
With cost push inflation, the price of the good or service dramatically increases due to increase in the cost of raw material, or production. This causes the supply of a product or service to diminish and with low supply but an increase in demand, prices can and will rise.
Devaluation
When the Central Bank prints more money via Quantitative Easing or any other mechanism, it can lead to inflation as more money is available, low interest rates and easy cost of borrowing, more consumers will take loans and spend the money, thereby increasing prices. There is a large supply of money so as spending increases, the target asset inflates in price.
Which Inflation Rate is good
Most Central Banks aim to have an inflation rate of between 2% and 2.5%. A small amount of inflation is beneficial to the economy and this amount will vary depending on the state of the economy and other factors.
Keeping inflation at the desired rate is a balancing act the Central Banks try to maintain. However things do happen in an economy that cause inflation to rise.
There are a number of effects that can be seen in an economy when inflation is high.
- $1,000,000 is not what it used to be: Rising inflation means your money will not go as far as it should because the purchasing power is reduced.
- People spend or and invest: With the knowledge that money is reducing in purchasing power, more people are eager to spend it or invest it in an asset. Each passing day, cash loses value and for businesses that need to make large purchases this makes a difference.
- May cause more inflation: As more people are spending, if demand grows faster than supply, it can cause more inflation.
- Higher cost of borrowing: People and businesses that needs loans will need to pay more for borrowing.
- Wages: Workers are likely to demand more wages to keep up with the cost of living due to the increase in inflation.
How is Inflation Measured and Controlled
The rate of inflation in the US is measured using the Consumer Price Index. The CPI measures the weighted average of the prices of basket of goods and services that a consumer will need. This includes food, medicines, travel and other necessities. CPI is calculated by taking the change in the price over a period of time for those same items.
Another index that can be used is the Whole Price Index or WPI. This examines the wholesale prices of items even before it gets to the consumers.
Inflation rate = (Final CPI Index Value) / (Initial CPI value) * 100
Depending on the cause of inflation, there are number of things the central bank can do to control inflation. If the sharp rise in inflation is caused by a weakness in the currency, the Central Bank may choose to print less currency.
If it caused by a super abundance of money, interest rates could be raised in order to curb spending and encourage more saving.
Can Inflation be reverted: Will it go on forever
Inflation is useful in an economy because there are benefits when inflation grows. Depending on the cause of inflation, the economy can experience some much needed growth especially during a recovery from a recession.
When inflation is getting high, there are a number of measures the Central Bank may decide to take which include reducing the rate of quantitative easing or raising interest rates.
Inflation cannot go high forever because it will lead ultimately to hyper inflation and history has shown that does not need well.
In the end the economy will default, violence may well ensue and the government will need to come up with a way to determine the value of their currency.
Can Inflation be bad and when it is a problem
Inflation is a balancing act and the Central Bank aims to meet its inflation target that will work for the economy. A low inflation rate can be bad for the economy because it can denote a lack of demand in the economy. If consumers are not eager to spend, business will suffer and begin to fail which will lead to unemployment, stagflation or even deflation.
A certain amount of inflation is not bad and is necessary however if inflation rises rapidly over a short period of time, we can have another situation where unemployment will increase as the cost of doing business goes up and businesses may decide to cut staff to manage costs.
How to protect against High Inflation
An inflation hedge in this sense means you take steps to protect your portfolio from the negative impacts of high inflation. Here are a number of ways you can hedge against inflation.
Real Estate
High inflation has a positive effect on asset classes such as real estate because the value increases so having some of your portfolio in real estate will is useful in protecting long term against inflation.
Stocks
The stock market can be positively or negatively impacted by inflation and you the aim is to look for companies that will benefit from a rise in consumer prices or from a weaker currency and invest in those as hedge.
Gold or other Precious Metals
Gold is a store of value and investors usually move their money to gold when inflation increases. You can own gold via an ETF so you do not have the physical gold but if you can have physical gold, well, that is just grand.
Floating Rate Bonds
A Bond will usually pay a fixed payment for the duration of the Bond however with a floating rate bond, the payout increases as inflation increases.
TIPS: This stands for Treasury Inflation Protected Securities. They are government bonds and protect from inflation as they indexed to inflation so if inflation rises, the interest paid out will increase too.
Inflation with low Interest Rates
Interest rates are a way the central bank can manage inflation. When interest rates are low, generally there is growth in the economy and inflation increases as a result.
To reduce the rate of inflation, interest rates can be raised and when that happens, growth can slow down. There is an inverse relationship between inflation and interest rates.
How Inflation affects Businesses
Business cover different sectors of the economy and a high rate of inflation will affect businesses differently. In a situation where inflation is driven by high consumer spending, businesses providing the service to consumers can benefit.
If the cause of inflation as a result of cheap money and low interest rates due to the Central Bank printing more of the currency, companies that purchase products or inventory can see their performance impacted as money loses its purchasing power.
Situations like this make it difficult for businesses to plan because of uncertainty. Some may stock up on products or cut staff to keep costs down.
How Inflation affects the Stock Market
The stock markets consists of different types of companies across a range of sectors and as an investor, depending on your investing strategy you choose to employ, rising inflation may be good for you or may not be. Let us consider a number of examples.
If you are have adapted an income investing strategy or one that focuses on dividends, during periods of high inflation, stocks that pay dividends may be more attractive to new investors because they tend to be cheaper. Remember dividends are paid in cash and with high inflation, cash is losing its purchasing power so as you can imagine, some investors would rather not have these stocks in their portfolio.
With lower interprets rates and more money in people’s pockets, the money often ends up in the stock market or crypto as we have seen in more recent cases. Investors have money money, the cost of borrowing is cheap so investor look to spend that money in the stock market.
It is difficult to decisively determine how inflation will affect the broad market and a prudent investor should look each company on its merits based on their investment style. Growth stocks will behave differently to value stocks during high inflation and one thing that can be seen from the market is that there is increased volatility.
How Inflation can affect Real Estate
When there is cheap money or excessive spending and inflation rises as a result, many investors tend to invest in asset classes such as real estate because of capital appreciation. The value of the currency is weaker so you need ‘more’ of it to purchase the same asset such as Real Estate.
Investing in Real Estate is one of they ways investors protect their portfolio against rising inflation because the value of the Real Estate increases with high inflation.
Looking at the broader market, Developers will see their costs go up due to a weaker currency and rising cost of materials. As home building costs increases, houses may be less affordable for many people so an investor with a number of properties can see gains in the property value during this time.
How Inflation can affect Bonds
To understand the effect of high inflation on Bonds, let us remind ourselves of what a Bond is and how it works. Using a simple example, when you purchase a Bond there are three main parts. What you pay for it, when it matures and how much interest you get each year.
So if you purchase a Bond for $100 at 5% interest for 5 years, it means you pay $100 for it and each year for 5 years you get 5% of $100 which is $5 a year for 5 years. At the end of the 5 years or maturity, you get back your $100 but in the meantime you have eared $5 a year for 5 years which is $25.
As inflation rises, your payout which is in cash is worth a loser amount because inflation has diminished to an extent the power of your $5 payout. Bond yields will be the same but the value of what you are getting will be reduced due to inflation eating into it.
One way to protect against this is by investing TIPS, aptly named Treasure Inflation Protected Securities and they are designed to eliminate the risk of lower returns due to high inflation.
How Inflation affects Cash
Even in times of low inflation, money is certainly not the best asset class as a store of your wealth. As we have covered in our article Wealth vs Money, money is or should be a temporary store of your labour not the final destination.
Inflation reduces the purchasing power of your money so it is the least desirable asset class to hold especially during inflation or to protect from the effects of inflation.
How Inflation affects Gold
Apart from Real Estate, Gold is seen as a good hedge from inflation. For thousands of years Gold has been seen and used as a store of real wealth and this is especially true during inflation. The price and value of assets rise during inflation and Gold benefits from this.
Final Note
Inflation measures the increase in the cost of a number of items over a period of time. The inflation rate is expressed as a percentage and reveals the increase in cost.
The most common way inflation is measured is using the CPI – Consumer Price Index which is a basket of a number of items that are deemed necessities. The price of these items are compared from the previous period and the current period and expressed as a percentage.
There can be one on multiple causes of inflation and while a certain amount of inflation is necessary to maintain a healthy economy a high inflation rate can negatively impact the economy with rising prices, and the need to increase wages to maintain the same level or quality of living.
Businesses may need to cope with any extra costs by down sizing or taking other measures to protect themselves.
Different industries will see different types of impact depending on the cause of the inflation and as a result will reflect differently on their stock price.
Inflation has different impact on different asset classes. Real Estate, Gold or TIPS perform better during inflation including Value stocks.
Bonds that are not adjustable and cash are negatively impacted by rising inflation because with Bonds, the realised payout is less due to high inflation and cash is just bad as its value goes down each day. The value of the cash is determined by what it can buy and with inflation, it can purchase less and less hence the weaker purchasing power.
Inflation benefits investors how have assets and those who have hedged their portfolio with adequate financial instruments that product against it. When it comes to pay rises, it should at least keep up with inflation otherwise what you are getting on paper and what you can actually purchase will be different.
Inflation is not bad thing and in many ways is a balancing act. The lesson is to be on the right side of the scale so regardless of what happens the economy, it tips in your favour.
